Follow the money: York University prof examines mutual fund fees

Douglas Cumming, entrepreneurship, finance, investing, mutual fund fees, mutual funds, Ontario Research Chairs, York University

York University professor of finance and entrepreneurship Douglas Cumming and his spouse, York instructor of finance Sofia Johan, say their recent report on mutual fund fees has friends making jokes about how they should go into hiding.

Each month, we will be featuring an Ontario Research Chair (ORC) from one of the province’s universities. ORCs are university research professorships, created to drive provincial research and develop excellence, to create world-class centres of research, and to enhance Ontario’s competitiveness in Canada’s knowledge-based economy. 

Douglas Cumming is not making friends in the mutual fund industry. But he is influencing people.

The professor of finance and entrepreneurship at York University recently did a study on trailer fees that led one fund manager to suggest an inscription for his gravestone: “Responsible for killing the Canadian mutual fund industry.” That’s because his report is likely to lead the Ontario Securities Commission (OSC) to change its policies on the fees later this year. Those changes could save investors—but cost the industry—billions of dollars.

Cumming is an Ontario Research Chair in Economics and Cross Cultural Studies, funded by an endowment from the government of Ontario. Part of his goal as chair is to identify policies that either promote or inhibit economic competitiveness.

For his mutual fund report, he teamed up with his spouse, York instructor of finance Sofia Johan, and PhD student Yelin Zhang. Together, they crunched data from mutual fund managers across the country to discover whether the controversial trailer fees affect sales. Technically, a trailer fee is the commission a mutual fund company pays to an investment advisor to sell its products. But clients end up paying the fee, usually about 1%, as part of the fund’s management expenses. As long as clients keep their money in the fund, their advisor gets a trailer fee every year, regardless of how the fund performs.

“Trailer fees cost Canadian investors over $5 billion a year collectively,” says Cumming. “Most people don’t even know they pay these fees because they are not clearly recorded. And funds that pay trailer fees don’t do better, but worse.”

Letting data dictate policy

It’s a hot topic in the business press because some banks and investment firms included trailer fees when calculating overall account management fees. The result was that clients paid double for their investments. Over the past few years, the OSC has ordered a number of banks and investment firms to pay back excess fees to customers.

Other jurisdictions have gone further by banning trailer fees altogether. The United Kingdom did it in 2006, the European Union in 2007, and Australia in 2010.

“They got rid of the fees on the notion there could be conflict of interest,” says Cumming. OSC head Maureen Jensen, on the other hand, has said publicly that she wants any move the commission makes to be backed by data.

Which is why the Canadian Securities Administrators (CSA), an umbrella organization for provincial and territorial securities regulators such as the OSC, asked Cumming and his team to follow the money. Their research for the CSA set out to answer two basic questions: Are advisors more apt to recommend mutual funds with higher trailer fees? And are they reluctant to remove clients from under-performing funds if they have trailer fees?

Cumming and his colleagues tracked the flow of investor money in and out of funds. The trail showed the answer to both questions was a resounding “yes.”

In January 2017, the CSA released a consultation paper based partly on their work, and OSC head Jensen says she intends to use it as a springboard for regulatory changes later this year.

“It would have worked out better for us if the results were the opposite,” says Cumming. “A lot of people are mad at us. Some friends have joked that we should change our address or go into hiding.”

When venture capital does more harm than good

But Cumming is taking aim at more than just mutual funds. Along with Johan and University of Toronto law professor Jeffrey MacIntosh, he is also shining a light on counter-productive policies around government venture capital. Venture capital is money investors loan to startup firms and small businesses they believe have long-term growth potential. It’s an important source of funding because startups don’t usually qualify for bank loans.

“Banks wouldn’t have invested in Facebook,” says Johan. “But these new companies are often the basis of our investments for retirement and savings.”

Their analysis shows that government-sponsored venture capital in Canada is akin to “a drop in an empty pond.” Their research, published the Journal of Industrial and Business Economics in November 2016, found the government of Ontario’s venture capital expenditures would have to be higher by $4.4 billion per year to achieve levels of venture capital/gross domestic product that are comparable to Massachusetts. Similarly, the government of Canada’s expenditures would have to be higher by $1.6 billion per year to achieve comparable venture capital/gross domestic product levels comparable to the United States.

Part of the problem, says Cumming, is the way governments invest in startups. They use something called Labour Sponsored Venture Capital Corporations (LSVCC). Governments offer very generous tax incentives for people to invest in the corporations, which in turn invest that money into startups. But LSVCCs must invest those funds within two years of receiving them, even if there are no suitable firms. The result is that LSVCCs can end up investing in companies that fail.

“It costs over $1 billion in forgone tax revenue and the program worsens the quality of the venture capital market,” says Cumming. Based partly on his analysis, the Ontario government phased out its LSVCC tax credit in 2011. Ottawa subsequently followed suit phasing out the federal LSVCC tax credit, but the Trudeau government’s 2016 federal budget reinstated it.  (Other  provinces still have LSVCC tax credits.)

Cumming and his colleagues have documented LSVCCs’ flaws for over a decade and he hopes their continued work will help inform efficient tax policy: “Empirical-based policy making is so important,” he says. “Otherwise, policy decisions are based on perceptions, and these perceptions can be distorted by a variety of things, including but not limited to conflicts of interest.”

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